What Is an Audit Trail?

An audit trail is a step-by-step record by which accounting, trade details, or other financial data can be traced to their source. Audit trails are used to verify and track many types of transactions, including accounting transactions and trades in brokerage accounts.

An audit trail is most often utilized when the accuracy of an item needs to be verified, as it might be in the case of an audit. Audit trails can be useful tools when determining the validity of an accounting entry, source of funds, or trade.

Understanding an Audit Trail

Audit trails can be used in accounting when an auditor or examiner needs to verify figures such as revenue, net earnings, or earnings per share (EPS). Transactions that are involved in computing a company's revenue, net earnings, or earnings per share are reviewed and the calculations may be redone if figures were incorrectly classified. The cost of goods sold (COGS), for example, is an expense item subtracted from gross revenue that's used when calculating net earnings. The COGS figure would be double-checked by verifying the transactions and data sources that went into calculating the cost of goods sold. All elements of the final numbers are double-checked along the audit trail to verify the final figure.

All public companies undergo a financial audit as part of their reporting responsibilities.

Types of Audit Trails

Audit trails, or rather the process of following an audit trail, are found in many different areas of finance. When buying a home, for example, a mortgage lender may utilize an audit trail to determine the source of funds for a down payment. They may ask to see a bank statement showing the deposit of funds into the account and ask for additional verification regarding the source of the deposit. The Securities and Exchange Commission (SEC) and NYSE will use audit trails for the explicit reconstruction of trades when there are questions about the validity or accuracy of trade data. This is done to ensure that the trades taking place on major exchanges are in compliance with current regulations. Of course, audit trails can also be used to track improper market activity. If it is believed, for example, that a particular entity is trading large volumes of a thinly traded stock for the purpose of manipulating the share price, a regulator can utilize an audit trail to help identify the culprit.

A regulator will then document and analyze all houses and brokers involved in specific trades for the offending security to determine whose activity is abnormal and who might be the manipulator. Depending on the complexity of the trading scheme being used, reconstructing the trade history may require forensic accounting in addition to audit trail data.

Advantages and Disadvantages of Audit Trails

Advantages

Audit trails are a vital tool used by accountants to hold corporations accountable for their actions. Without the use of audit trails to confirm financial information, there would be no reason to believe in the legitimacy of a company's financial reports. In this way, audit trails not only protect consumers from fraudulent reporting, they also help to stabilize the overall economy. Audit trails also force entities to maintain a thorough and updated audit log and trail system, which further cuts down on fraud and other types of financial crime. In industries such as healthcare, the meticulous keeping of audit logs helps ensure that sensitive information, such as HIPAA-protected data, can only be accessed by the appropriate parties. While audit trails provide financial information that is absolutely necessary for the smooth flow of business, there are challenges to maintaining and implementing the practice.

Disadvantages

The biggest issue faced by corporations is the time and money it takes to maintain a sufficiently compliant audit log, especially when the audit log is automated. Logs also may be difficult to navigate and store as they increase in size. Furthermore, access may be too broad, which can compromise the integrity of the data.  Finally, as in the case of banks looking to approve loans to their members, sometimes the requirements of audit trails are unnecessarily rigid. If, for example, a consumer fails to keep appropriate financial records, they may be unfairly rejected for loans for which they would otherwise be approved.

Market Auditing Systems

The Order Audit Trail System (OATS) is an automated trade entry system established by the Financial Industry Regulatory Authority (FINRA) that is used to record information relating to orders, quotes, and other trade-related data from all equities traded on the National Market System (NMS). This system simplifies an order's progression from its initial receipt to its eventual execution or cancellation, for easy tracking or auditing purposes.

One of the purposes of OATS is to monitor suspicious behavior and provide an audit trail for investigators. Because of the data that is recorded, anyone involved in suspicious activity is easier to find.

The Bottom Line

Audit trails support a company's financial statements by clearly marking how transactions proceeded. Audit trails are used to create financial statements and are used by auditors in verifying the financial statements. Without audit trails, it would be guesswork as to how a company's operations were handled. Audit trails provide proof of every business step.